Financial Policy and Corporate Strategy
What the exam tests
This domain links financial policy choices-investment, financing, dividend and liquidity-to corporate strategy and value creation. Questions often ask you to evaluate a strategic proposal, choose a capital structure, or critique a dividend decision using agency, signalling and stakeholder arguments.
Core rules
- Strategic financial management evaluates decisions by incremental after-tax cash flows and risk-adjusted NPV, not accounting profit.
- MM with corporate tax: levered value = unlevered value + PV(tax shield) − PV(financial distress costs). Debt is useful only while marginal tax benefit exceeds marginal distress and agency costs.
- Residual dividend policy: pay dividends only after funding positive-NPV investments at the target capital structure.
- Signalling: dividend increases and buybacks can signal management confidence but are costly; pecking order favours internal funds, then debt, then equity.
- Governance and ESG affect cost of capital, licence to operate and long-run cash flows.
Worked example
A firm has EBIT ₹500 crore, tax 30%, unlevered cost 12%, debt ₹1,000 crore at 10%, and PV of distress costs ₹100 crore. Unlevered value = 500(1−0.30)/0.12 = ₹2,916.7 crore. Tax shield = 0.30 × 1,000 = ₹300 crore. Levered value = 2,916.7 + 300 − 100 = ₹3,116.7 crore. Adding debt creates ₹200 crore net value, but not the full ₹300 crore tax shield.
Traps
Do not use PAT after interest as the unlevered cash flow; do not ignore distress costs or double-count interest in WACC; do not treat dividend irrelevance as valid when taxes, signalling and agency costs exist.